Impermanent partnerships: evaluating JVs
November 2018 | FEATURE | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
November 2018 Issue
Alliances are seldom ideal. It is human nature to be motivated by self-interest, and allies must overcome this emotion in order to establish a beneficial partnership. One type of alliance that is often an effective alternative to a merger, acquisition or organic growth is a joint venture (JV).
A JV offers participating companies many benefits. If chosen wisely, a JV partner can bring complementary capabilities and resources, access to a base of customers, distribution capabilities to reach them, and experienced and knowledgeable local employees. A JV can also be less risky than a straight acquisition.
Increasingly prized, according to the 2017 Bain & Company report ‘Tapping the Unexpected Potential of Joint Ventures’, the value of JVs grew 20 percent annually between 1995 and 2015, approximately twice the rate of mergers & acquisitions (M&A) transactions. The report also notes that over the past five years, JVs that were intended to accelerate growth were the most successful, with US deals yielding a 17 percent return on investment (ROI).
Although the report clearly characterises JVs as being of good repute, their worth is not always immediately obvious. “Many companies underestimate the potential JVs have to effectively execute strategy,” says Phil Leung, a partner at Bain & Company. “However, around 80 percent of the 250 executives surveyed in our report indicated that the JVs they have been involved with met or exceeded expectations and created value.”
In the view of Joseph J. Dehner, an attorney at Frost Brown Todd LLC, JVs are a means for businesses to accomplish what they cannot do without spending excessive capital. “In a populist world of trade wars and tightening borders, businesses are increasingly focusing on building long-lasting alliances with trusted local business partners in key markets and supply chains,” he affirms. “In recent years, the major trend has been network building rather than acquisition.”
Advantages and challenges
There are a number of reasons why a company may choose to pursue a JV. Participants may be looking to accelerate growth by accessing valuable assets, optimise cost by gaining scale, obtain access to new capabilities, reduce risk through a staged entry or exit of a business, or gain access to protected markets or industries that are subject to specific laws or government protection.
Gerard Baynham, a partner at Water Street Partners LLC, believes JVs provide many advantages relative to going-it-alone or full acquisitions. “JVs allow partners to quickly leverage market-specific know-how and infrastructure without the start-up time and costs of building it from scratch. They also benefit from a discounted price tag, shared risk, and preservation of the target’s people and culture, which can quickly attrit in acquisitions. When done well, JVs are advantaged by economies of scope, complementary assets and real skin-in-the-game from the owners.”
What then is the key to a successful JV? “Dealmakers should not approach JVs like M&A,” advises Mr Baynham. “Instead of trying to win the negotiation, they should foster an open, mutually beneficial and sustainable relationship. Control is limited in JVs and one unhappy partner can sink a JV or at least make it painful. The shareholders need to trust each other and be, at least, relatively well aligned on the JV’s objectives and plans.” According to Mr Leung, JVs can be a particularly successful lever for either scale or scope. “Scale deals make up around 20 percent of JVs and aim to combine businesses for economies of scale. Scope deals make up the remaining 80 percent of deals and aim to bring together capabilities and assets for a stronger business.”
For all their advantages, JVs do come with significant challenges. Chief among these is the need for partners to agree a venture’s overall strategy and objectives, while ensuring that any fragility in their relationship does not compromise the aims of the JV and lead to its termination. “The pitfalls of a JV include unclear strategic intent and benefits for each JV partner, insufficient diligence selecting the right partner and a failure to reflect changing market environments and evolving interests in governance models,” says Mr Leung. “It is important to take a disciplined approach and continued attention is required to make a JV a success.”
Notable JVs in 2018
Testament to their current favour, major JVs have not been hard to come by this year, with notable transactions being seen across a number of jurisdictions, China in particular. For example, in the first half of 2018, there was a high volume of new JVs announced between Western and Chinese auto manufacturers to make and sell electric vehicles.
Much of this activity stems from China’s status as the world’s largest electric vehicle (EV) market, its industrial policies which prioritise EVs as part of the ‘Made in China 2025’ state-led industrial plan and fuel consumption targets and quotas for the number of EVs sold. Examples of EV JVs include Volkswagen and Anhui Jianghuai Automobile Group Corp., Ford and Anhui Zotye Automobile Co., BMW and Great Wall Motor, and Nissan and DongFeng. In addition, General Motors has committed to selling 20 types of EVs in China by 2023, and will do so through its 10 Chinese JVs.
“This is interesting because, in April 2018, China announced it will remove the current 50 percent cap it places on foreign automakers’ ownership of local automotive JVs,” explains Peter Daniel, a partner at Water Street Partners LLC. “If JVs will no longer be required, why are foreign companies rushing to do them? The answer is they do not believe they can compete in China alone. Foreign companies need local market know-how and resources. A good test will be how Tesla fares against an army of long-established JVs should it decide to go it alone in China.”
For his part, Mr Daniel has observed significant, recent JV activity by airlines, with big carriers, such as Delta Air Lines, “carving up the world” via JVs. “Delta has a trans-Atlantic JV with Air France-KLM and Virgin Atlantic, a trans-Pacific JV with Korean Air, and a transborder JV with Canada’s WestJet, not to mention its 49 percent ownership of Aeromexico,” he says.
Another notable JV in recent months is Elysis – a company formed by Alcoa and Rio Tinto to make aluminium via a revolutionary process that produces only oxygen as a by-product, eliminating all direct greenhouse gas emissions from the traditional smelting process.
“The technology involved has the potential to be revolutionary in that it eliminates greenhouse gases from aluminium smelting,” explains Mr Baynham. “The number of partners the shareholders were able to engage was without question impressive, including investments from Apple and the governments of Canada and Quebec. Both Apple chief executive Tim Cook and Canadian prime minister Justin Trudeau have been publicly quoted discussing this venture.”
One issue always critical in business and which provides the impetus for many JVs is regulation. “New or changing regulations often spur waves of JV activity,” says Mr Baynham. “This happened in the US when the Affordable Care Act (Obamacare) was enacted in 2010. It led to a number of partnerships between healthcare providers and payors.”
Regulatory issues are also arising due to the isolationist policies adopted by many countries following the emergence of populist forces across the globe – forces that tend to build walls rather than bridges. “Ironically, this heightens the need for local business partners on a JV basis,” suggests Mr Dehner. “Increased regulation, such as extraterritorial banking sanctions, tariffs and a restrictive new Committee on Foreign Investment in the United States (CFIUS) statute, increases the prevalence of contractual JVs which, in turn, require astute use of cross-border technology and legal solutions.”
JV regulatory considerations have also been impacted, albeit indirectly, by the evolving US-China trade relationship. “The Trump administration has floated the idea of placing restrictions on US companies that take technologies such as robotics and artificial intelligence (AI) to China,” continues Mr Baynham. “Separately, but possibly relatedly, China has indicated that it is considering allowing foreign companies to do more in China without having to form a JV. Time will tell what sort of impact these potential regulations have on the number of JVs between US and Chinese companies.”
While a disciplined approach, over-investing in partner screening, clarifying strategic intent and defining a strong, flexible operating model remain key JV success factors, significant issues remain for those contemplating a partnership.
One of these issues, according to David Ernst, co-founder and managing director at Water Street Partners LLC, has already begun to have a major impact on JV activity. “The potential for sharply higher tariffs will drive US companies to form more ventures with a production base in their target markets,” he believes. “Similarly, it will encourage foreign companies to invest directly in the US through 100 percent-owned firms, as well as JV vehicles.”
Generally though, Mr Ernst expects JV activity to remain strong, driven by similar trends as in the past. These include the need to penetrate and grow in new markets (Asia especially), the desire to share risk and costs (such as huge projects in upstream oil and gas), and partnerships aimed at innovation that bring together companies with different core competencies.
For some commentators, future JV activity will involve increased business efforts to forge contractual cross-border JVs. “This will be especially so for supply chains, digital services, and the design, branding and marketing of global products adapted for cultural and economic differences,” says Mr Dehner. “The most overlooked compliance issues today involve personal data privacy, tax and sanction matters, anti-corruption practices and tail personnel risks. As a result, cross-culturally sensitive managers will be in high demand.”
As long as it lasts
Defining a strategy, choosing the right partner, designing an operating model, setting it up and adapting it to critical changes over its lifetime are of key importance in the execution of a JV.
Moreover, when delivered effectively, JVs bring together an impressive set of complementary capabilities and resources. At the same time, patience and understanding is a must, as there are many hurdles to clear while JV partners build and maintain strategic alignment in the expectation of a successful alliance – a partnership that is likely to last only as long as it is mutually beneficial.
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